Libor Rate Scandal and How was it Manipulated

Libor scam is believed to have occurred between 2007 and 2009, however it came to light only recently in June 2012. The scam revolves around the fact that traders at certain reputed banks tamper with LIBOR rates to suite their respective trading positions. LIBOR is an important rate that influences many financial instruments. In addition to providing an interbank lending rate and baseline for other lending rates, LIBOR also influences derivative contracts. Eurodollar futures and interest rate swaps are derivatives that are influenced significantly by LIBOR. The collectively worth of these financial products where LIBOR plays a key role (especially when it comes to pricing) is an astronomical figure – USD 350 Trillion.

WHAT IS LIBOR?

As per Investopedia An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers’ Association. The LIBOR is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year.

In Layman Term Libor is short for the London Interbank Offered Rate, a measure of the cost of borrowing between banks and a crucial benchmark for interest rates worldwide. It’s actually a collection of rates generated for 10 currencies across 15 different time periods, ranging from one day to one year. In simpler terms, LIBOR is the reference rate at which Bank A can borrow from Bank B.

Now, imagine a situation where Bank A suspects the financial position (cash flows, liquidity) of a bunch of banks with which it does regular business. Under such circumstance, if Bank A were to lend money these banks then obviously it would do so, but at a higher lending rate. A higher rate would adequately compensate the risk involved in lending money to these financial weak banks. So going by this logic, if the LIBOR rates are high then it indicates that the banks are generally scared to lend to each other. Conversely, low LIBOR rate indicates that prevailing trust amongst the banks is high hence they are willing to tender cheaper loans. So simply put LIBOR rates can be used as a proxy to check the financial health of the banking and financial services industry.

How does it affect consumers?

The most basic way the LIBOR is used is for a financial instrument with variable interest rates to set that interest rate as “LIBOR + 5%” or “LIBOR + 2%” (naturally, financiers have far more complicated formulas than that, but the use of the LIBOR as the starting number is a constant). A financial instrument could be a mortgage, or the loan to your bank which your bank then calculates its variable rate mortgages on, or the interest rate swap that your bank uses to hedge against exchange rate movements

Libor is the world’s most important benchmark for interest rates. Roughly $10 trillion in loans — including credit card rates, car loans, student loans and adjustable-rate mortgages — as well as some $350 trillion in derivatives are tied to Libor.

If Libor goes up, your monthly interest rate payments may go up with it. If it goes down, some borrowers will enjoy lower interest rates, but mutual funds and pensions with investments in Libor-based securities will earn less in interest.

How is LIBOR rate calculated?

Unlike many other financial products that are available, LIBOR is not a publicly traded instrument. For instance, the price of Aluminum (AL) is ‘discovered’ on a continuous basis by traders trading AL on the London Metal Exchange. Hence it would be fair to believe that the price of AL what you see is probably reflective of its fair value as millions of traders are publicly trading the metal.

Libor rates are set each business day through a process overseen by the British Bankers’ Association. The British Bankers Association (BBA) conducts a daily poll – asking 18 banks across 3 continents ‘How much will it cost their bank if they had to borrow money for 15 different borrowing periods ranging from an overnight loan to a yearly loan’. The poll is conducted from before 11:30AM London time. The responses are collected by Thomson Reuters on behalf of BBA, which removes a certain percentage of the highest and lowest figures before calculating the averages and creating the Libor quotes.

What’s the controversy all about?

So far, Barclays Bank is the prime suspect. In light of the scam, its Chief Executive, Bob Diamond stepped down, besides the bank had to cough up USD 453 Million in fines to settle charges.

The manipulation involved tweaking the LIBOR rate deliberately to suite bank’s trading positions. The bank’s trading desk usually take huge positions on rate sensitive financial products such as interest rate swaps, currency futures and other exotic derivatives contracts. The profitability of these positions would depend upon many factors including the way LIBOR moves. Hence there is an incentive for the banks to tweak the LIBOR rates so that they generate trading profits.

To understand how the rates can be tweaked, here’s a very basic example. Imagine the following are the LIBOR rates Bank 1 to 18 have submitted to BBA.

In order to calculate the LIBOR, the first four highest (B3,B9,B10,B11) and lowest(B1,B2,B7,B12) rates are thrown out. The remainder 10 rates will be averaged out to get the LIBOR. In this case the average turns out to be 4.572% and hence the LIBOR is fixed at 4.572%.

Now imagine a situation where Bank 8 would benefit if the LIBOR rates were higher than what it’s actually supposed to be. Under such circumstance B8 would deliberately attempt to tweak the rates so that the overall LIBOR rate turns out to be higher…and how exactly would Bank 8 achieve this feat? Quite simple, they simply submit a higher rate!!

Now because 5.1 is relatively higher, B8 will replace B3 and join B9,B10 and B11 in the highest bidders club. B3 will now get pushed into getting averaged out….and naturally what follows is a higher LIBOR rate. If we take the B8’s tweaked rate, the new LIBOR rate would work out to 4.599%….a good 0.6% higher than the ‘true rate’. Now if you appreciate the world of high finance and leveraged instruments, you can imagine what 0.6% can translate into with respect to trading profits.

The two activities of the bank – LIBOR submission and trading are separate activities of the bank. LIBOR submission is a mechanical process and should be separated from the activities of the trading desk. It should not represent the needs of the trading desk, rather should represent the good trust estimate of the banking system.

Barclays is only the tip of the iceberg. However, suspicion has now fallen on all the banks that participate in the Libor process. Deutsche Bank , Royal Bank of Scotland , Credit Suisse , Citigroup and JPMorgan Chase are among the institutions that have acknowledged they are being investigated by regulators.

Given Libor’s vast reach and the number of global firms that may be involved in its manipulation, the scandal is prompting calls for resignations, criminal prosecutions, and stricter regulation of the financial sector.

The simplicity of this scam is alarming. Barclays may have been the start of it all, but it’s pretty clear it wasn’t the end.

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